Baker Hughes Has Significant Valuation Upside Potential

| About: Baker Hughes (BHI)

As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Baker Hughes' (NYSE:BHI) case, we think the firm is undervalued. We think the firm is fairly valued at $57 per share. Our report on Baker Hughes and hundreds of other companies can be found here.

For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation and relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation on our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best.

If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Baker Hughes posts a VBI score of 6 on our scale, reflecting our 'undervalued' DCF assessment of the company, its attractive relative valuation versus peers, and bearish technicals. We use Halliburton (NYSE:HAL), Cameron International (NYSE:CAM), National Oilwell Varco (NYSE:NOV), and Schlumberger (NYSE:SLB) as its peer group.

Our Report on Baker Hughes

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Investment Considerations

Investment Highlights

Baker Hughes scores fairly well on our business quality matrix. The firm has put up solid economic returns for shareholders during the past few years with relatively low volatility in its operating results. Return on invested capital (excluding goodwill) has averaged 11.7% during the past three years.

The firm's shares are trading at an attractive level at this time. Given the company's track record of solid business performance, we are taking a closer look at picking up some of the firm's shares in the portfolio of our Best Ideas Newsletter. In the spirit of transparency, we disclose the performance of our Best Ideas Newsletter below:

Baker Hughes' valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple
and PEG ratio also look attractive versus peers.

That said, Baker Hughes' cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about -2.5% during the past three years, much lower than the mid-single-digit range we'd expect for cash cows. Total debt-to-EBITDA was 1 last year, while debt-to-book capitalization stood at 20.5%.

The firm's shares have underperformed the market benchmark during the past quarter. Although Baker Hughes' valuation appears attractive, the company is currently exhibiting characteristics of a potential value trap (based on its pricing action), and we'd still be cautious at these levels. There may be a better entry point yet.

The firm experienced an operating cash flow CAGR of about -2.3% during the past 3 years. We expect its operating cash flow growth to be better than its peer median during the next five years.

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (NASDAQ:ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Baker Hughes' 3-year historical return on invested capital (without goodwill) is 11.7%, which is above the estimate of its cost of capital of 9.5%. As such, we assign the firm a ValueCreation™ rating of GOOD. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Baker Hughes' free cash flow margin has averaged about -2.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. We are the only firm that makes available fully-populated DCF valuation models to our financial-advisor clients (allowing them to arrive at their own customized fair value) on our website at At Baker Hughes, cash flow from operations increased about 22% from levels registered two years ago, while capital expenditures expanded about 127% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Baker Hughes'hares are worth between $44.00 - $70.00 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $57 per share represents a price-to-earnings (P/E) ratio of about 14.4 times last year's earnings and an
implied EV/EBITDA multiple of about 6.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 18.7%. Our model reflects a 5-year projected average operating margin of 13.7%, which is above Baker Hughes' trailing 3-year average. Beyond year 5, we assume free
cash flow will grow at an annual rate of 5.4% for the next 15 years and 3% in perpetuity. For Baker Hughes, we use a 9.5% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $57 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Baker Hughes. We think the firm is attractive below $44 per share (the green line), but quite expensive above $70 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Baker Hughes' fair value at this point in time to be about $57 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Baker Hughes' expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $75 per share in Year 3 represents our existing fair value per share of $57 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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